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FranklinStrategic Mortgage Portfolio

MARCH 31, 2011

SEMIANNUAL REPORTAND SHAREHOLDER LETTER

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Franklin Templeton InvestmentsGain From Our Perspective®

Franklin Templeton’s distinct multi-manager structure combines thespecialized expertise of three world-class investment management groups—Franklin, Templeton and Mutual Series.

Each of our portfolio management groups operates autonomously, relying on its own research and staying true to the unique investment disciplines that underlie its success.

Franklin. Founded in 1947, Franklin is a recognized leader in fixed income investingand also brings expertise in growth- and value-style U.S. equity investing.

Templeton. Founded in 1940, Templeton pioneered international investing and, in 1954, launched what has become the industry’s oldest global fund. Today, withoffices in over 25 countries, Templeton offers investors a truly global perspective.

Mutual Series. Founded in 1949, Mutual Series is dedicated to a unique style of value investing, searching aggressively for opportunity among what it believes are undervalued stocks, as well as arbitrage situations and distressed securities.

Because our management groups work independently and adhere to differentinvestment approaches, Franklin, Templeton and Mutual Series funds typicallyhave distinct portfolios. That’s why our funds can be used to build trulydiversified allocation plans covering every major asset class.

At Franklin Templeton Investments, we seek to consistently provide investors with exceptional risk-adjusted returns over the long term, as well as the reliable,accurate and personal service that has helped us become one of the most trustednames in financial services.

TRUE DIVERSIFICATION

RELIABILITY YOU CAN TRUST

SPECIALIZED EXPERTISE

MUTUAL FUNDS | RETIREMENT PLANS | 529 COLLEGE SAVINGS PLANS | SEPARATE ACCOUNTS

Not part of the semiannual report

Not part of the semiannual report | 1

Shareholder LetterDear Shareholder:

During the six months ended March 31, 2011, we welcomed steady, increas-ingly convincing signs of economic improvement both in the U.S. and abroad.Companies generally reported strong profit growth, and momentum picked upfor productivity, manufacturing, foreign trade and consumer spending. As creditconditions improved, banks increased lending to businesses. The U.S. economicrecovery, however, continued to be uncertain in light of high unemployment,continued housing market losses, and rising budget deficits at the federal, stateand local levels. To promote the pace of recovery, the Federal Reserve Boardkept interest rates at a historically low level during the six-month period andimplemented another monetary stimulus plan. Encouraged by the favorabledevelopments, many investors reentered the stock markets, which posted solidgains for the period under review. However, toward period-end, rising globalinflation in some regions, the spread of geopolitical instability in North Africaand the Middle East, and Japan’s devastating earthquake and tsunami pressuredequity markets worldwide.

Although conditions remain challenging, our experience gives us reason to be optimistic about the potential for continued market stabilization and economic growth. Keep in mind we have navigated through past periods ofeconomic uncertainty by remaining committed to our long-term perspectiveand disciplined investment approach.

Franklin Strategic Mortgage Portfolio’s semiannual report goes into greaterdetail about prevailing conditions during the period under review. In addition,you will find Fund performance data, financial information and a discussionfrom the portfolio manager. Please remember all securities markets fluctuate,as do mutual fund share prices.

NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE

Semiannual Report

Franklin Strategic Mortgage Portfolio . . . . . 3

Performance Summary . . . . . . . . . . . . . . . . 7

Your Fund’s Expenses . . . . . . . . . . . . . . . . . 9

Financial Highlights and Statement of Investments . . . . . . . . . . . . . . 11

Financial Statements . . . . . . . . . . . . . . . . . 17

Notes to Financial Statements . . . . . . . . . . 20

Shareholder Information . . . . . . . . . . . . . . . 30

Shareholder Letter . . . . . . . . . . . . . . . . . . . 1

Contents

If you would like more frequent updates, franklintempleton.com provides dailyprices, monthly performance figures, portfolio holdings and other information.You can also access your account, buy and sell shares, and find helpful finan-cial planning tools. We hope you will take advantage of these online services.

In a constantly changing market environment, we adhere to our disciplinedapproach as we manage the Fund, keeping in mind the trust you have placedin us. As always, we recommend investors consult their financial advisors andreview their portfolios to design a long-term strategy and portfolio allocationthat meet their individual needs, goals and risk tolerance. We firmly believemost people benefit from professional advice and that advice is invaluable asinvestors navigate current market conditions.

We thank you for investing with Franklin Templeton, welcome your questionsand comments, and look forward to serving your investment needs in theyears ahead.

Sincerely,

Christopher J. Molumphy, CFAPresident and Chief Executive Officer – Investment ManagementFranklin Strategic Mortgage Portfolio

CFA® is a trademark owned by CFA Institute.

This letter reflects our analysis and opinions as of March 31, 2011. The information is not a complete analysis of every aspect of any market, country, industry, security or fund. Statements of fact are from sources considered reliable.

2 | Not part of the semiannual report

Semiannual Report | 3

We are pleased to bring you Franklin Strategic Mortgage Portfolio’s semian-nual report for the period ended March 31, 2011.

Performance Overview

For the six months under review, Franklin Strategic Mortgage Portfolio –Class A delivered a +5.20% cumulative total return. The Fund outperformedthe +0.84% total return of its benchmark, the Citigroup U.S. Broad Investment-Grade (USBIG) Mortgage Index, which is the mortgage component of theCitigroup USBIG Bond Index.2 For comparison, the Lipper U.S. MortgageFunds Classification Average, which consists of funds chosen by Lipper thatinvest primarily in mortgages and securities issued or guaranteed by the U.S.government and certain federal agencies,1 returned +0.94%; and the BarclaysCapital (BC) U.S. Treasury Index, the U.S. Treasury component of the BC U.S.

Semiannual Report

Franklin Strategic Mortgage PortfolioYour Fund’s Goal and Main Investments: Franklin Strategic Mortgage Portfolio seeks

high total return (a combination of high current income and capital appreciation) relative to the perform-

ance of the general mortgage securities market by investing at least 80% of its net assets in a portfolio

of mortgage securities. The Fund normally focuses its investments in mortgage pass-through securities,

which are securities representing interests in “pools” of mortgage loans issued or guaranteed by the

U.S. government, its agencies or instrumentalities. Some of the Fund’s investments may include securities

issued by government-sponsored entities, such as Fannie Mae and Freddie Mac.1

1. Securities owned by the Fund but not shares of the Fund are guaranteed by the U.S. government, its agencies orinstrumentalities as to the timely payment of principal and interest. Although U.S. government-sponsored entities maybe chartered or sponsored by acts of Congress, their securities are neither insured nor guaranteed by the U.S. Treasury.Please refer to the Fund’s prospectus for a detailed discussion regarding various levels of credit support for govern-ment agency or instrumentality securities. The Fund’s yield and share price are not guaranteed and will fluctuate withmarket conditions.

2. Source: © 2011 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstarand/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete ortimely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use ofthis information. The index is unmanaged and includes reinvestment of any income or distributions. One cannot investdirectly in an index, and an index is not representative of the Fund’s portfolio.

The dollar value, number of shares or principal amount, and names of all portfolio holdings are listed in the Fund’sStatement of Investments (SOI). The SOI begins on page 12.

Performance data represent

past performance, which does

not guarantee future results.

Investment return and principal

value will fluctuate, and you may

have a gain or loss when you sell

your shares. Current performance

may differ from figures shown.

Please visit franklintempleton.comor call (800) 342-5236 for most

recent month-end performance.

4 | Semiannual Report

Government Index, had a -2.79% total return.3 You can find the Fund’s long-term performance data in the Performance Summary beginning on page 7.

Economic and Market Overview

The U.S. economy expanded during the six-month reporting period largely dueto rising exports, shrinking imports and greater consumer and business spend-ing. The job market improved, and employment increased for six consecutivemonths while the unemployment rate declined from 9.6% in September 2010to 8.8% in March 2011.4 Remaining challenges to sustained economic recoveryincluded elevated debt concerns and a struggling housing sector.

Early in the period, consumers were concerned about disappointing employmentnumbers, declines in home sales and fears of a renewed economic slowdown.The Federal Reserve Board (Fed) kept interest rates low, and in November, topromote a stronger recovery, the Fed announced its intention to buy $600 billionof longer term Treasury securities by the end of the second quarter of 2011.

Crude oil prices began the reporting period at $80 per barrel. Geopoliticalinstability in North Africa and the Middle East caused oil prices to reach a six-month high of $107 at period-end. As oil and food prices rose, the pace of inflation accelerated during the period.

Investor concerns about weak economic data, the potential spillover effects ofthe European debt crisis, turmoil in North Africa and the Middle East, and themultiple crises triggered by Japan’s earthquake, tsunami and nuclear disaster ledto market volatility. At times of uncertainty, wary investors favored short-termTreasuries, and Treasury yields dipped to low levels for much of the period. Latein the period, cautious confidence in economic recovery helped fuel an equitymarket rally, which dampened Treasury prices. In addition, the potential forhigher inflation made many investors reluctant to buy longer term Treasuries.For the six-month period under review, Treasury prices fell and yields rose. Thetwo-year Treasury bill yield began the period at 0.42% and ended at 0.80%,while the 10-year Treasury note yield rose from 2.53% to 3.47%.

3. Source: Lipper Inc. For the six-month period ended 3/31/11, this category consisted of 96 funds. Lipper calculationsdo not include sales charges or subsidization by a fund’s manager. The Fund’s performance relative to the averagemight have differed if these or other factors had been considered.

Source: © 2011 Morningstar. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; theirinterest payments and principal are guaranteed. The Fund’s investment return and share price fluctuate with marketconditions.

The indexes are unmanaged and include reinvestment of any income or distributions. One cannot invest directly in anindex, and an index is not representative of the Fund’s portfolio.

4. Source: Bureau of Labor Statistics.

Portfolio BreakdownBased on Total Investments as of 3/31/11

Federal National Mortgage Association (Fannie Mae)

Federal Home Loan Mortgage Corp. (Freddie Mac)

Asset-Backed Securities & Commercial Mortgage-Backed Securities

Government National Mortgage Association (Ginnie Mae)

Short-Term Investments

47.4%

20.8%

15.5%

2.2%

14.1%


Investment Strategy

We invest at least 80% of the Fund’s net assets in mortgage securities.Normally we focus on mortgage pass-through securities issued or guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac. At least 65% of total assets are invested in securities rated AAA by Standard & Poor’s (S&P), or Aaa byMoody’s Investors Service (Moody’s), independent credit rating agencies.5

For the remaining 35% of portfolio securities, up to 15% may be invested insecurities rated below BBB by S&P, or Baa by Moody’s. If unrated, securitieswill be deemed of comparable quality by the Fund’s manager. Within theseparameters, we rely on our research to help us identify attractive investmentopportunities.

Manager’s Discussion

At the start of the reporting period, U.S. economic data was mixed, but byperiod-end, the economic growth appeared to accelerate. Retail sales werefairly healthy, the labor market showed signs of healing and the corporate sector remained relatively strong. Yet, amid increasing geopolitical risks andconcerns over rising commodity prices, U.S. consumer confidence fell in March.Overall inflation, however, remained subdued as slack in the employment sector kept labor inflation contained. In our view, although the U.S. economyseems to be on a path to recovery, the U.S. housing market remains depressedand the impact of higher oil prices and massive budget deficits pose potentialrisks to economic expansion.

Mortgage securities continued to perform well during the period. Overall performance was driven by slower prepayments and investor expectations forcontinued moderation of prepayment rates. Although prepayment risk remainedheightened, actual prepayment levels were constrained and generally slowed dueto the associated cost of refinancing, loss of home equity, tighter underwritingstandards and declining home prices.

Many fixed income sectors continued to post positive returns during the period.Commercial mortgage-backed securities (CMBS) posted strong absolute returnsand were among the best performing fixed income sectors. Conventional FannieMae and Freddie Mac mortgage-backed securities (MBS) delivered positivereturns and outperformed comparable maturity U.S. Treasury securities.

Franklin Strategic Mortgage Portfolio’s broad mortgage strategy looks acrossall mortgage opportunity sets to find relative value. The team continued to

5. STANDARD & POOR’S®, S&P® and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC.Standard & Poor’s does not sponsor, endorse, sell or promote any S&P index-based product.

Dividend Distributions*10/1/10–3/31/11

Month Dividend per Share

October 3.2519 cents

November 3.5219 cents

December** 4.0343 cents

January 3.6949 cents

February 3.7125 cents

March 3.7112 cents

Total 21.9267 cents

*Assumes shares were purchased and held for theentire accrual period. Since dividends accrue daily, youractual distributions will vary depending on the date youpurchased your shares and any account activity. AllFund distributions will vary depending upon currentmarket conditions, and past distributions are notindicative of future trends.

**Includes an additional 0.66 cent per share distribu-tion to meet excise tax requirements.

look for strong cash flow fundamentals and valuations to uncover opportunitiesacross the mortgage investment universe. We reduced our allocation to somemid-coupon MBS (5.0%) in favor of lower coupon MBS (4.0% and 4.5%).

For most of the period, we emphasized higher quality, securitized sectors as wefound what we considered fundamentally sound bonds at attractive yields inthese markets. The Fund continued to benefit from its CMBS exposure and weremained allocated to the sector, but took the opportunity to reduce exposurein some higher quality securities that had delivered strong performance. We marginally decreased our exposure to asset-backed securities as relative pricesand fundamentals remained in line, and we viewed the sector as fairly valued.

Thank you for your continued participation in Franklin Strategic MortgagePortfolio. We look forward to serving your future investment needs.

Roger A. Bayston, CFA

Paul Varunok

Portfolio Management TeamFranklin Strategic Mortgage Portfolio

The foregoing information reflects our analysis, opinions and portfolio holdings as of March 31, 2011, the end ofthe reporting period. The way we implement our main investment strategies and the resulting portfolio holdings maychange depending on factors such as market and economic conditions. These opinions may not be relied upon asinvestment advice or an offer for a particular security. The information is not a complete analysis of every aspectof any market, country, industry, security or the Fund. Statements of fact are from sources considered reliable,but the investment manager makes no representation or warranty as to their completeness or accuracy. Althoughhistorical performance is no guarantee of future results, these insights may help you understand our investmentmanagement philosophy.



Performance Summary as of 3/31/11

Price and Distribution Information

Class A (Symbol: FSMIX) Change 3/31/11 9/30/10

Net Asset Value (NAV) +$0.25 $9.34 $9.09

Distributions (10/1/10–3/31/11)

Dividend Income $0.219267

Your dividend income will vary depending on dividends or interest paid by securities in the Fund’sportfolio, adjusted for operating expenses. Capital gain distributions are net profits realized fromthe sale of portfolio securities. The performance table does not reflect any taxes that a shareholderwould pay on Fund dividends, capital gain distributions, if any, or any realized gains on the sale ofFund shares. Total return reflects reinvestment of the Fund’s dividends and capital gain distributions,if any, and any unrealized gains or losses.

Performance1

Cumulative total return excludes the sales charge. Average annual total return includes the maximum sales charge. Class A: 4.25% maximum initial sales charge.

Class A 6-Month 1-Year 5-Year 10-Year

Cumulative Total Return2 +5.20% +10.83% +29.26% +62.98%

Average Annual Total Return3 +0.76% +6.15% +4.36% +4.55%

Distribution Rate4 4.47%

30-Day Standardized Yield5 2.69%

Total Annual Operating Expenses6 0.72%

Performance data represent past performance, which does not guarantee future results. Investment return and principalvalue will fluctuate, and you may have a gain or loss when you sell your shares. Current performance may differ from figures shown. For most recent month-end performance, go to franklintempleton.com or call (800) 342-5236.

Performance Summary (continued)


Endnotes

The Fund’s share price and yield will be affected by interest rate movements and mortgage prepayments. During periods of declining interestrates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore the Fund may be forced toreinvest returned principal at lower interest rates, reducing income. Bond prices generally move in the opposite direction of interest rates. Thus,as prices of bonds in the Fund adjust to a rise in interest rates, the Fund’s share price may decline. The manager applies various techniquesand analyses in making investment decisions for the Fund, but there can be no guarantee that these decisions will produce the desired results.The Fund’s prospectus also includes a description of the main investment risks.

1. Past expense reductions by the Fund’s manager increased the Fund’s total returns. If the manager had not taken this action, the Fund’s totalreturns would have been lower.

2. Cumulative total return represents the change in value of an investment over the periods indicated.

3. Average annual total return represents the average annual change in value of an investment over the periods indicated. Six-month return has notbeen annualized.

4. Distribution rate is based on an annualization of the sum of distributions per share for the last 30 days of March and the maximum offering priceof $9.75 on 3/31/11.

5. The 30-day standardized yield for the month ended 3/31/11 reflects an estimated yield to maturity (assuming all portfolio securities are held tomaturity). It should be regarded as an estimate of the Fund’s rate of investment income, and it may not equal the Fund’s actual income distributionrate (which reflects the Fund’s past dividends paid to shareholders) or the income reported in the Fund’s financial statements.

6. Figures are as stated in the Fund’s prospectus current as of the date of this report. In periods of market volatility, assets may decline significantly,causing total annual Fund operating expenses to become higher than the figures shown.

Your Fund’s Expenses


As a Fund shareholder, you can incur two types of costs:

• Transaction costs, including sales charges (loads) on Fund purchases; and

• Ongoing Fund costs, including management fees, distribution and service (12b-1) fees, and otherFund expenses. All mutual funds have ongoing costs, sometimes referred to as operating expenses.

The following table shows ongoing costs of investing in the Fund and can help you understandthese costs and compare them with those of other mutual funds. The table assumes a $1,000investment held for the six months indicated.

Actual Fund Expenses

The first line (Actual) for each share class listed in the table provides actual account values andexpenses. The “Ending Account Value” is derived from the Fund’s actual return, which includesthe effect of Fund expenses.

You can estimate the expenses you paid during the period by following these steps. Of course,your account value and expenses will differ from those in this illustration:

1. Divide your account value by $1,000.If an account had an $8,600 value, then $8,600 ÷ $1,000 = 8.6.

2. Multiply the result by the number under the heading “Expenses Paid During Period.”If Expenses Paid During Period were $7.50, then 8.6 x $7.50 = $64.50.

In this illustration, the estimated expenses paid this period are $64.50.

Hypothetical Example for Comparison with Other Funds

Information in the second line (Hypothetical) for each class in the table can help you compareongoing costs of investing in the Fund with those of other mutual funds. This information may not be used to estimate the actual ending account balance or expenses you paid during the period.The hypothetical “Ending Account Value” is based on the actual expense ratio for each class andan assumed 5% annual rate of return before expenses, which does not represent the Fund’s actualreturn. The figure under the heading “Expenses Paid During Period” shows the hypotheticalexpenses your account would have incurred under this scenario. You can compare this figure withthe 5% hypothetical examples that appear in shareholder reports of other funds.

Your Fund’s Expenses (continued)


Please note that expenses shown in the table are meant to highlight ongoing costs and do not reflectany transaction costs, such as sales charges. Therefore, the second line for each class is useful incomparing ongoing costs only, and will not help you compare total costs of owning different funds.In addition, if transaction costs were included, your total costs would have been higher. Please referto the Fund prospectus for additional information on operating expenses.

Beginning Account Ending Account Expenses Paid During Class A Value 10/1/10 Value 3/31/11 Period* 10/1/10–3/31/11

Actual $1,000 $1,052.00 $3.43

Hypothetical (5% return before expenses) $1,000 $1,021.59 $3.38

*Expenses are calculated using the most recent six-month annualized expense ratio of 0.67%, multiplied by the average account value over theperiod, multiplied by 182/365 to reflect the one-half year period.

Franklin Strategic Mortgage PortfolioFinancial Highlights

Semiannual Report | The accompanying notes are an integral part of these financial statements. | 11

Six Months EndedMarch 31, 2011 Year Ended September 30,

(unaudited) 2010 2009 2008 2007 2006

Per share operating performance(for a share outstanding throughout the period)

Net asset value, beginning of period . . . . . . . . . . $9.09 $8.75 $8.80 $9.42 $9.59 $9.73

Income from investment operationsa:

Net investment income . . . . . . . . . . . . . . . . . . . 0.143 0.333 0.306 0.404 0.476 0.418

Net realized and unrealized gains (losses) . . . . . . 0.326 0.487 0.163 (0.493) (0.129) (0.069)

Total from investment operations . . . . . . . . . . . . . 0.469 0.820 0.469 (0.089) 0.347 0.349

Less distributions from net investment income . . . (0.219) (0.480) (0.519) (0.531) (0.517) (0.489)

Redemption feesb . . . . . . . . . . . . . . . . . . . . . . . . — — — —c —c —c

Net asset value, end of period . . . . . . . . . . . . . . . $9.34 $9.09 $8.75 $8.80 $9.42 $9.59

Total returnd . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.20% 9.61% 5.69% (1.04)% 3.70% 3.73%

Ratios to average net assetse

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.67% 0.70% 0.67%f 0.57%f 0.57%f 0.55%f

Net investment income . . . . . . . . . . . . . . . . . . . . 3.13% 3.76% 4.16% 4.58% 5.05% 4.48%

Supplemental data

Net assets, end of period (000’s) . . . . . . . . . . . . . $100,169 $100,549 $101,961 $168,674 $243,664 $287,865

Portfolio turnover rate . . . . . . . . . . . . . . . . . . . . . 225.80% 341.45% 273.38% 336.36% 326.67% 247.03%

Portfolio turnover rate excluding mortgage dollar rollsg . . . . . . . . . . . . . . . . . . . . . . . . . . . 32.11% 20.82% 9.39% 25.39% 30.85% 38.75%

aThe amount shown for a share outstanding throughout the period may not correlate with the Statement of Operations for the period due to the timing of sales and repurchases ofthe Fund shares in relation to income earned and/or fluctuating market value of the investments of the Fund.bEffective September 1, 2008, the redemption fee was eliminated.cAmount rounds to less than $0.001 per share.dTotal return does not reflect sales commissions or contingent deferred sales charges, if applicable, and is not annualized for periods less than one year.eRatios are annualized for periods less than one year.fBenefit of expense reduction rounds to less than 0.01%.gSee Note 1(f) regarding mortgage dollar rolls.

Franklin Strategic Mortgage PortfolioStatement of Investments, March 31, 2011 (unaudited)

Principal Amount* Value

Asset-Backed Securities and Commercial Mortgage-Backed Securities 22.4%


Finance 22.4%aAFC Home Equity Loan Trust, 1997-4, 2A2, 0.89%, 12/22/27 . . . . . . . . . . . . . . . . . . . . . . . 293,258 $ 225,890aAmeriquest Mortgage Securities Inc., 2003-12, M2, 1.95%, 1/25/34 . . . . . . . . . . . . . . . . . . 808,755 331,368Banc of America Commercial Mortgage Inc.,

2006-1, AM, 5.421%, 9/10/45 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100,000 1,134,4542006-4, AM, 5.675%, 7/10/46 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 307,530

a,bBayview Commercial Asset Trust, 2006-CD1A, A-1, 144A, 1.491%, 7/25/23 (Canada) . . . . . . 631,176 CAD 635,881aBear Stearns Alt-A Trust, 2004-13, A2, 1.13%, 11/25/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . 446,697 336,878Bear Stearns Commercial Mortgage Securities Inc., 2006-PW13, AJ, 5.611%, 9/11/41 . . . . . . 750,000 713,414CitiFinancial Mortgage Securities Inc., 2003-4, AF6, 4.493%, 10/25/33 . . . . . . . . . . . . . . . . 1,389,043 1,397,468Citigroup/Deutsche Bank Commercial Mortgage Trust, 2006-CD3, AJ, 5.688%, 10/15/48 . . . . 450,000 401,665Countrywide Home Loans, 2004-J8, 3A3, 5.50%, 12/25/34 . . . . . . . . . . . . . . . . . . . . . . . . . 83,386 83,856

a,bCredit Suisse Mortgage Capital Certificates, 2006-TF2A, A2, 144A, 0.425%, 10/15/21 . . . . . 425,497 410,268aFirst Franklin Mortgage Loan Asset-Backed Certificates, 2004-FF11, 1A2, 0.60%, 1/25/35 . . . 280,716 259,808FNMA,

a2007-1, NF, 0.50%, 2/25/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655,049 652,034G93-33, K, 7.00%, 9/25/23 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,251,607 1,391,897

GE Capital Commercial Mortgage Corp., 2003-C1, A4, 4.819%, 1/10/38 . . . . . . . . . . . . . . . . 1,262,683 1,319,437GMAC Commercial Mortgage Securities Inc., 2005-C1, B, 4.936%, 5/10/43 . . . . . . . . . . . . . 800,000 603,342Greenwich Capital Commercial Funding Corp., 2004-GG1, A7, 5.317%, 6/10/36 . . . . . . . . . . 1,174,000 1,257,723

aGS Mortgage Securities Corp. II, 2007-GG10, A4, 5.804%, 8/10/45 . . . . . . . . . . . . . . . . . . . 1,000,000 1,063,265aHomebanc Mortgage Trust, 2005-4, A1, 0.52%, 10/25/35 . . . . . . . . . . . . . . . . . . . . . . . . . . 223,024 171,082aJPMorgan Chase Commercial Mortgage Securities Corp.,

2004-CB9, A4, 5.358%, 6/12/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,084,0182006-CB14, AM, 5.446%, 12/12/44 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,010,7982006-CB14, B, 5.536%, 12/12/44 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 666,347

Lehman ABS Corp., 2003-1, A1, 5.00%, 12/25/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,484,068 1,525,660aMorgan Stanley Capital I Trust, 2004-IQ7, A4, 5.40%, 6/15/38 . . . . . . . . . . . . . . . . . . . . . . . 2,050,000 2,198,882aNovastar Home Equity Loan, 2004-4, M4, 1.90%, 3/25/35 . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 1,105,013Residential Asset Securities Corp.,

2004-KS1, AI4, 4.213%, 4/25/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356,027 352,134a2005-AHL2, A2, 0.51%, 10/25/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81,485 78,382

a,bStructured Asset Securities Corp., 2005-SC1, 1A1, 144A, 0.52%, 5/25/31 . . . . . . . . . . . . . . 633,840 350,573aTravelers Mortgage Services Inc., 1998-5A, A, 2.53%, 12/25/18 . . . . . . . . . . . . . . . . . . . . . . 75,137 74,908

a,bWachovia Bank Commercial Mortgage Trust, 2007-WHL8, A1, 144A, 0.335%, 6/15/20 . . . . . . 366,307 341,076Wells Fargo Mortgage Backed Securities Trust,

a2004-W, A9, 2.762%, 11/25/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437,826 437,0532007-3, 3A1, 5.50%, 4/25/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550,584 574,260

Total Asset-Backed Securities and Commercial Mortgage-Backed Securities (Cost $22,626,905) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,496,364

Mortgage-Backed Securities 101.7%aFederal Home Loan Mortgage Corp. (FHLMC) Adjustable Rate 9.9%FHLMC, 2.125%, 4/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,646 32,666FHLMC, 2.241%, 11/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214,858 216,184FHLMC, 2.315%, 5/01/20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,521 129,927FHLMC, 2.415%, 11/01/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,347 70,513FHLMC, 2.445%, 3/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149,512 150,531FHLMC, 2.461%, 7/01/22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 782,451 824,802

Franklin Strategic Mortgage PortfolioStatement of Investments, March 31, 2011 (unaudited) (continued)



Mortgage-Backed Securities (continued)aFederal Home Loan Mortgage Corp. (FHLMC) Adjustable Rate (continued)FHLMC, 2.48%, 1/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,420 $ 49,698FHLMC, 2.543%, 5/01/22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,747 55,006FHLMC, 2.625%, 4/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,844 55,897FHLMC, 2.626%, 1/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,503 149,286FHLMC, 2.803%, 12/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,804 93,858FHLMC, 2.975%, 7/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,222 45,464FHLMC, 2.976%, 4/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,839 66,840FHLMC, 3.033%, 8/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,492 29,732FHLMC, 3.973%, 4/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,748 127,638FHLMC, 4.576%, 1/01/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234,030 245,667FHLMC, 5.206%, 11/01/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,556,158 4,781,103FHLMC, 5.258%, 4/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,366 1,005,699FHLMC, 5.706%, 7/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493,318 497,074FHLMC, 5.903%, 10/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,554 113,435FHLMC, 5.934%, 10/01/36 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 968,025 1,023,091FHLMC, 6.876%, 11/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113,186 121,315

9,885,426

Federal Home Loan Mortgage Corp. (FHLMC) Fixed Rate 20.1%FHLMC Gold 15 Year, 7.00%, 7/01/11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 61FHLMC Gold 15 Year, 8.00%, 12/01/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,998 3,030

cFHLMC Gold 30 Year, 4.00%, 4/01/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,800,000 3,732,314cFHLMC Gold 30 Year, 4.50%, 4/01/40 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500,000 4,573,125FHLMC Gold 30 Year, 5.00%, 10/01/33 - 7/01/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 709,604 745,347FHLMC Gold 30 Year, 5.50%, 9/01/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252,235 270,990FHLMC Gold 30 Year, 6.00%, 7/01/28 - 12/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,347 30,068

cFHLMC Gold 30 Year, 6.00%, 4/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000,000 7,604,842FHLMC Gold 30 Year, 6.50%, 2/01/19 - 7/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 620,741 699,423FHLMC Gold 30 Year, 7.50%, 10/01/25 - 8/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 498,395 578,725FHLMC Gold 30 Year, 8.00%, 7/01/24 - 5/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,815 173,339FHLMC Gold 30 Year, 8.50%, 10/01/17 - 9/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184,451 213,124FHLMC Gold 30 Year, 9.00%, 9/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102,202 123,577FHLMC Gold 30 Year, 9.50%, 12/01/16 - 4/01/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630,909 736,407FHLMC PC 30 Year, 8.50%, 2/01/17 - 5/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561,980 625,934FHLMC PC 30 Year, 9.00%, 6/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 972 1,102FHLMC PC 30 Year, 9.25%, 8/01/14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,926 3,202FHLMC PC 30 Year, 9.50%, 8/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,955 61,640

20,176,250

aFederal National Mortgage Association (FNMA) Adjustable Rate 14.3%FNMA, 1.913%, 4/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,568 46,013FNMA, 2.325%, 4/01/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,882 11,325FNMA, 2.329%, 4/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,134 22,756FNMA, 2.375%, 9/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,258 40,521FNMA, 2.402%, 12/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,046 52,617FNMA, 2.424%, 4/01/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,564 131,845FNMA, 2.435%, 12/01/22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,502 91,018FNMA, 2.445%, 5/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103,517 108,972FNMA, 2.45%, 8/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145,222 146,135




Mortgage-Backed Securities (continued)aFederal National Mortgage Association (FNMA) Adjustable Rate (continued)FNMA, 2.476%, 7/01/14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,098 $ 133,163FNMA, 2.478%, 7/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799,224 844,769FNMA, 2.49%, 11/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298,265 314,248FNMA, 2.50%, 11/01/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122,921 129,194FNMA, 2.508%, 7/01/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,693 54,606FNMA, 2.52%, 7/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127,984 128,746FNMA, 2.573%, 2/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,141 105,616FNMA, 2.583%, 4/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,970 99,246FNMA, 2.648%, 8/01/29 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,603 38,403FNMA, 2.665%, 10/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292,795 309,521FNMA, 2.675%, 9/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404,919 426,480FNMA, 2.715%, 5/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,941 26,170FNMA, 2.758%, 1/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,383,649 1,406,181FNMA, 2.775%, 6/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349,230 352,478FNMA, 2.835%, 10/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181,082 181,732FNMA, 3.02%, 7/01/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,435 39,677FNMA, 3.198%, 1/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458,588 475,325FNMA, 3.313%, 10/01/36 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,775,930 1,879,167FNMA, 3.763%, 10/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181,691 193,376FNMA, 4.106%, 5/01/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196,976 205,768FNMA, 4.22%, 7/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,794 82,997FNMA, 4.395%, 8/01/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114,616 120,778FNMA, 4.426%, 5/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,026 186,850FNMA, 4.611%, 4/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,354 147,423FNMA, 4.717%, 7/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503,096 529,995FNMA, 4.784%, 12/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,393 76,063FNMA, 4.857%, 9/01/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,901,889 5,144,484FNMA, 5.049%, 6/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,384 69,680

14,353,338

Federal National Mortgage Association (FNMA) Fixed Rate 54.2%FNMA 15 Year, 5.00%, 6/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486,845 521,339FNMA 15 Year, 5.00%, 7/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,688,717 1,808,366FNMA 15 Year, 5.50%, 5/01/14 - 2/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,485,253 1,611,411

cFNMA 15 Year, 5.50%, 4/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,630,000 5,008,359FNMA 15 Year, 6.50%, 5/01/14 - 10/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113,013 123,861FNMA 15 Year, 7.00%, 11/01/11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 65FNMA 15 Year, 7.50%, 6/01/11 - 7/01/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,948 4,973

cFNMA 30 Year, 4.00%, 3/01/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,600,000 9,444,000cFNMA 30 Year, 4.00%, 6/15/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 1,954,376cFNMA 30 Year, 4.50%, 4/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,700,000 8,856,330FNMA 30 Year, 5.00%, 4/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 777,951 819,804

cFNMA 30 Year, 5.00%, 4/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 1,569,375FNMA 30 Year, 5.50%, 11/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,545,740 2,738,519FNMA 30 Year, 5.50%, 9/01/33 - 11/01/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,095,379 5,488,305FNMA 30 Year, 6.00%, 10/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,693,676 2,961,689FNMA 30 Year, 6.00%, 10/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,080,735 1,189,278FNMA 30 Year, 6.00%, 12/01/23 - 8/01/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,805,841 1,987,874

cFNMA 30 Year, 6.00%, 4/15/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300,000 2,501,609




Mortgage-Backed Securities (continued)Federal National Mortgage Association (FNMA) Fixed Rate (continued)FNMA 30 Year, 6.50%, 12/01/27 - 8/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,825,133 $ 4,327,709FNMA 30 Year, 7.50%, 8/01/25 - 5/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,385 129,505FNMA 30 Year, 8.00%, 1/01/25 - 7/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,871 71,262FNMA 30 Year, 8.50%, 11/01/26 - 11/01/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629,214 737,628FNMA 30 Year, 9.00%, 12/01/16 - 9/01/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,175 49,726FNMA 30 Year, 9.50%, 11/01/15 - 4/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,758 161,857FNMA 30 Year, 10.00%, 7/01/16 - 4/01/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,469 122,107FNMA 30 Year, 10.50%, 4/01/22 - 5/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,734 12,437FNMA 30 Year, 12.00%, 4/01/15 - 5/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,733 1,793FNMA 30 Year, 12.50%, 12/01/13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 295FNMA GL 30 Year, 10.00%, 8/01/15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,787 19,230FNMA PL 30 Year, 10.00%, 9/01/20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,396 23,460

54,246,542

aGovernment National Mortgage Association (GNMA) Adjustable Rate 0.2%GNMA, 2.125%, 11/20/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,465 58,273GNMA, 2.625%, 7/20/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137,855 142,383

200,656

Government National Mortgage Association (GNMA) Fixed Rate 3.0%GNMA I SF 15 Year, 7.00%, 4/15/14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,765 7,249GNMA I SF 15 Year, 8.00%, 9/15/15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,640 21,562GNMA I SF 30 Year, 6.50%, 1/15/24 - 9/15/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449,338 509,026GNMA I SF 30 Year, 7.00%, 5/15/17 - 2/15/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371,238 421,193GNMA I SF 30 Year, 7.50%, 10/15/23 - 10/15/29 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,828 81,235GNMA I SF 30 Year, 8.00%, 1/15/17 - 9/15/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207,299 238,328GNMA I SF 30 Year, 8.25%, 1/15/21 - 5/15/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,835 151,334GNMA I SF 30 Year, 8.50%, 6/15/16 - 7/15/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256,004 285,756GNMA I SF 30 Year, 9.00%, 9/15/16 - 8/15/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,416 33,461GNMA I SF 30 Year, 10.00%, 12/15/18 - 2/15/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,238 6,287GNMA I SF 30 Year, 10.50%, 1/15/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 736 742GNMA II SF 30 Year, 6.50%, 1/20/26 - 1/20/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552,441 623,720GNMA II SF 30 Year, 7.50%, 11/20/22 - 7/20/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356,702 412,866GNMA II SF 30 Year, 8.00%, 1/20/17 - 8/20/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,256 122,154GNMA II SF 30 Year, 8.50%, 7/20/16 - 8/20/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,806 55,653GNMA II SF 30 Year, 9.00%, 11/20/19 - 3/20/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,652 5,508GNMA II SF 30 Year, 10.50%, 6/20/20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 23

2,976,097

Total Mortgage-Backed Securities (Cost $99,392,256) . . . . . . . . . . . . . . . . . . . . 101,838,309

Total Investments before Short Term Investments (Cost $122,019,161) . . . . . . 124,334,673

Short Term Investments 20.4%U.S. Government and Agency Securities (Cost $99,982) 0.1%

d,eU.S. Treasury Bill, 5/26/11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 99,994

Total Investments before Money Market Funds and Repurchase Agreements (Cost $122,119,143) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,434,667


16 | The accompanying notes are an integral part of these financial statements. | Semiannual Report

Shares Value

Short Term Investments (continued)Money Market Funds (Cost $4,994,444) 5.0%

f,g Institutional Fiduciary Trust Money Market Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,994,444 $ 4,994,444

Principal Amount

Repurchase Agreements (Cost $15,355,546) 15.3%h Joint Repurchase Agreement, 0.085%, 4/01/11 (Maturity Value $15,355,583) . . . . . . . . . . . $15,355,546 15,355,546

Barclays Capital Inc. (Maturity Value $2,556,088)BNP Paribas Securities Corp. (Maturity Value $2,017,724)Credit Suisse Securities (USA) LLC (Maturity Value $1,614,179)Deutsche Bank Securities Inc. (Maturity Value $2,441,845)HSBC Securities (USA) Inc. (Maturity Value $2,017,724)Merrill Lynch, Pierce, Fenner & Smith Inc. (Maturity Value $2,017,724)Morgan Stanley & Co. Inc. (Maturity Value $2,017,724)UBS Securities LLC (Maturity Value $672,575)Collateralized by U.S. Government Agency Securities, 0.00% - 6.27%, 4/11/11 - 1/26/16;

eU.S. Treasury Bills, 4/07/11 - 4/15/11; and U.S. Treasury Notes, 1.00% - 2.875%, 10/31/11 - 11/30/15 (valued at $15,688,261)

Total Investments (Cost $142,469,133) 144.5% . . . . . . . . . . . . . . . . . . . . . . . . . . 144,784,657

Securities Sold Short (2.0)% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,987,188)

Other Assets, less Liabilities (42.5)% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (42,628,801)

Net Assets 100.0% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,168,668

Securities Sold Short (Proceeds $1,997,188) (2.0)%Government National Mortgage Association (GNMA) Fixed Rate (2.0)%

c,iGNMA I SF, 30 Year, 4.00%, 6/15/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 $ (1,987,188)

See Abbreviations on page 29.

*The principal amount is stated in U.S. dollars unless otherwise indicated.aThe coupon rate shown represents the rate at period end.bSecurity was purchased pursuant to Rule 144A under the Securities Act of 1933 and may be sold in transactions exempt from registration only to qualified institutional buyers or in a public offering registered under the Securities Act of 1933. These securities have been deemed liquid under guidelines approved by the Fund’s Board of Trustees. At March 31,2011, the aggregate value of these securities was $1,737,798, representing 1.73% of net assets.cSecurity traded on a to-be-announced basis. See Note 1(d).dSecurity or a portion of the security has been segregated as collateral for open future contracts.eThe security is traded on a discount basis with no stated coupon rate.fNon-income producing.gSee Note 7 regarding investments in the Institutional Fiduciary Trust Money Market Portfolio.hSee Note 1(c) regarding joint repurchase agreement.iSecurity sold on a to-be-announced basis resulting in a short position. As such, the Fund is not subject to the deposit requirement or fees and expenses associated with short sale transactions.

At March 31, 2011, the Fund had the following financial futures contracts outstanding. See Note 1(e).

Number of Notional Unrealized UnrealizedDescription Type Contracts Value Expiration Date Appreciation Depreciation

U.S. Long Bond . . . . . . . . . . . . . . . . . . . . . . . . . Long 24 $2,884,500 6/21/11 $21,690 $ —

Franklin Strategic Mortgage PortfolioFinancial Statements


Statement of Assets and LiabilitiesMarch 31, 2011 (unaudited)

Assets:Investments in securities:

Cost - Unaffiliated issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,119,143Cost - Sweep Money Fund (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,994,444Cost - Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,355,546

Total cost of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $142,469,133

Value - Unaffiliated issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $124,434,667Value - Sweep Money Fund (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,994,444Value - Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,355,546

Total value of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,784,657Receivables:

Investment securities sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,277,843Capital shares sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383,427Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345,473

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147,791,400

Liabilities:Payables:

Investment securities purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,154,825Capital shares redeemed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290,913Affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,345Distributions to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,630

Securities sold short, at value (proceeds $1,997,188) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,987,188Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,831

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,622,732

Net assets, at value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,168,668

Net assets consist of:Paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $137,366,295Distributions in excess of net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (815,689)Net unrealized appreciation (depreciation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,347,215Accumulated net realized gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (38,729,153)

Net assets, at value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,168,668

Shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,721,924

Net asset value per sharea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9.34

Maximum offering price per share (net asset value per share ÷ 95.75%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9.75

aRedemption price is equal to net asset value less contingent deferred sales charges, if applicable.

Franklin Strategic Mortgage PortfolioFinancial Statements (continued)

18 | The accompanying notes are an integral part of these financial statements. | Semiannual Report

Statement of Operationsfor the six months ended March 31, 2011 (unaudited)

Investment income:Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,898,233

Expenses:Management fees (Note 3a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195,243Transfer agent fees (Note 3d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,436Custodian fees (Note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,011Reports to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,282Registration and filing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,408Professional fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,207Trustees’ fees and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,826Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,126

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336,539

Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,561,694

Realized and unrealized gains (losses):Net realized gain (loss) from:

Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,432,718)Foreign currency transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15,436)

Net realized gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,447,673)

Net change in unrealized appreciation (depreciation) on:Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,975,107Translation of other assets and liabilities denominated in foreign currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

Net change in unrealized appreciation (depreciation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,975,271

Net realized and unrealized gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,527,598

Net increase (decrease) in net assets resulting from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,089,292

Franklin Strategic Mortgage PortfolioFinancial Statements (continued)


Statements of Changes in Net Assets

Six Months EndedMarch 31, 2011 Year Ended

(unaudited) September 30, 2010Increase (decrease) in net assets:

Operations:Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,561,694 $ 3,791,640Net realized gain (loss) from investments, foreign currency transactions and

futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,447,673) (1,057,939)Net change in unrealized appreciation (depreciation) on investments and translation of other assets and liabilities denominated in foreign currencies . . . . . . . . . . . . . . . . . . 9,975,271 6,527,702

Net increase (decrease) in net assets resulting from operations . . . . . . . . . . . . . . 5,089,292 9,261,403Distributions to shareholders from net investment income . . . . . . . . . . . . . . . . . . . . . . . (2,373,108) (5,422,467)Capital share transactions (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,096,558) (5,250,752)

Net increase (decrease) in net assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (380,374) (1,411,816)Net assets:

Beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,549,042 101,960,858

End of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,168,668 $100,549,042

Distributions in excess of net investment income included in net assets:End of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (815,689) $ (4,275)

Franklin Strategic Mortgage PortfolioNotes to Financial Statements (unaudited)


1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Franklin Strategic Mortgage Portfolio (Trust) is registered under the Investment Company Act of 1940, as amended, (1940 Act) as an open-end investment company, consisting of one fund,the Franklin Strategic Mortgage Portfolio (Fund).

The following summarizes the Fund’s significant accounting policies.

a. Financial Instrument Valuation

The Fund’s investments in securities and other financial instruments are carried at fair value daily.Fair value is the price that would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants on the measurement date. Under proceduresapproved by the Fund’s Board of Trustees, the Fund may utilize independent pricing services,quotations from securities and financial instrument dealers, and other market sources to deter-mine fair value.

Debt securities generally trade in the over-the-counter market rather than on a securities exchange.The Fund’s pricing services use multiple valuation techniques to determine fair value. In instanceswhere sufficient market activity exists, the pricing services may utilize a market-based approachthrough which quotes from market makers are used to determine fair value. In instances wheresufficient market activity may not exist or is limited, the pricing services also utilize proprietaryvaluation models which may consider market characteristics such as benchmark yield curves,option-adjusted spreads, credit spreads, estimated default rates, coupon rates, anticipated timingof principal repayments, underlying collateral, and other unique security features in order to estimate the relevant cash flows, which are then discounted to calculate the fair value. Securitiesdenominated in a foreign currency are converted into their U.S. dollar equivalent at the foreignexchange rate in effect at the close of the NYSE on the date that the values of the foreign debtsecurities are determined. Derivative financial instruments (derivatives) listed on an exchange are valued at the official closing price of the day. Investments in open-end mutual funds are valued at the closing net asset value. Repurchase agreements are valued at cost, which approxi-mates market value.

The Fund has procedures to determine the fair value of securities and other financial instrumentsfor which market prices are not readily available or which may not be reliably priced. Under theseprocedures, the Fund primarily employs a market-based approach which may use related or com-parable assets or liabilities, recent transactions, market multiples, book values, and other relevantinformation for the investment to determine the fair value of the investment. The Fund may alsouse an income-based valuation approach in which the anticipated future cash flows of the invest-ment are discounted to calculate fair value. Discounts may also be applied due to the nature orduration of any restrictions on the disposition of the investments. Due to the inherent uncertaintyof valuations of such investments, the fair values may differ significantly from the values thatwould have been used had an active market existed.

Franklin Strategic Mortgage PortfolioNotes to Financial Statements (unaudited) (continued)


1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (continued)

b. Foreign Currency Translation

Portfolio securities and other assets and liabilities denominated in foreign currencies are trans-lated into U.S. dollars based on the exchange rate of such currencies against U.S. dollars on thedate of valuation. The Fund may enter into foreign currency exchange contracts to facilitatetransactions denominated in a foreign currency. Purchases and sales of securities, income andexpense items denominated in foreign currencies are translated into U.S. dollars at the exchangerate in effect on the transaction date. Portfolio securities and assets and liabilities denominatedin foreign currencies contain risks that those currencies will decline in value relative to the U.S.dollar. Occasionally, events may impact the availability or reliability of foreign exchange ratesused to convert the U.S. dollar equivalent value. If such an event occurs, the foreign exchangerate will be valued at fair value using procedures established and approved by the Fund’s Boardof Trustees.

The Fund does not separately report the effect of changes in foreign exchange rates from changesin market prices on securities held. Such changes are included in net realized and unrealized gainor loss from investments on the Statement of Operations.

Realized foreign exchange gains or losses arise from sales of foreign currencies, currency gains orlosses realized between the trade and settlement dates on securities transactions and the differ-ence between the recorded amounts of dividends, interest, and foreign withholding taxes and theU.S. dollar equivalent of the amounts actually received or paid. Net unrealized foreign exchangegains and losses arise from changes in foreign exchange rates on foreign denominated assets andliabilities other than investments in securities held at the end of the reporting period.

c. Joint Repurchase Agreement

The Fund may enter into a joint repurchase agreement whereby its uninvested cash balance isdeposited into a joint cash account with other funds managed by the investment manager or anaffiliate of the investment manager and is used to invest in one or more repurchase agreements.The value and face amount of the joint repurchase agreement are allocated to the funds basedon their pro-rata interest. A repurchase agreement is accounted for as a loan by the fund to theseller, collateralized by securities which are delivered to the fund’s custodian. The market value,including accrued interest, of the initial collateralization is required to be at least 102% of thedollar amount invested by the funds, with the value of the underlying securities marked to mar-ket daily to maintain coverage of at least 100%. The joint repurchase agreement held by theFund at period end had been entered into on March 31, 2011.

d. Securities Traded on a TBA Basis

The Fund may trade securities on a to-be-announced (TBA) basis, with payment and deliveryscheduled for a future date. These transactions are subject to market fluctuations and are subject




d. Securities Traded on a TBA Basis (continued)

to the risk that the value at delivery may be more or less than the trade date price. Although the Fund will generally purchase these securities with the intention of holding the securities, it may sell the securities before the settlement date. Sufficient assets have been segregated forthese securities.

e. Derivative Financial Instruments

The Fund invested in derivatives in order to manage risk or gain exposure to various other invest-ments or markets. Derivatives are financial contracts based on an underlying or notional amount,require no initial investment or an initial net investment that is smaller than would normally berequired to have a similar response to changes in market factors, and require or permit net settle-ment. Derivatives contain various risks including the potential inability of the counterparty tofulfill their obligations under the terms of the contract, the potential for an illiquid secondarymarket, and/or the potential for market movements which expose the Fund to gains or losses inexcess of the amounts shown on the Statement of Assets and Liabilities. Realized gain and lossand unrealized appreciation and depreciation on these contracts for the period are included inthe Statement of Operations.

The Fund entered into financial futures contracts primarily to manage interest rate risk. Afutures contract is an agreement between the Fund and a counterparty to buy or sell a securityfor a specific price on a future date. Required initial margin deposits of cash or securities arepledged by the Fund. Subsequent payments, known as variation margin, are made or received by the Fund, depending on fluctuations in the value of the underlying security. Such variationmargin is accounted for as unrealized appreciation or depreciation until the contract is closed, at which time the gains or losses are realized.

See Note 9 regarding other derivative information.

f. Mortgage Dollar Rolls

The Fund may enter into mortgage dollar rolls, typically on a TBA basis. Mortgage dollar rollsare agreements between the Fund and a financial institution to simultaneously sell and repur-chase mortgage-backed securities at a future date. Gains or losses are realized on the initial sale,and the difference between the repurchase price and the sale price is recorded as an unrealizedgain or loss to the fund upon entering into the mortgage dollar roll. In addition, the Fund mayinvest the cash proceeds that are received from the initial sale. During the period between thesale and repurchase, the Fund is not entitled to principal and interest paid on the mortgagebacked securities. The risks of mortgage dollar roll transactions include the potential inability ofthe counterparty to fulfill its obligations.




g. Income Taxes

It is the Fund’s policy to qualify as a regulated investment company under the Internal RevenueCode. The Fund intends to distribute to shareholders substantially all of its taxable income andnet realized gains to relieve it from federal income and excise taxes. As a result, no provision forU.S. federal income taxes is required. The Fund files U.S. income tax returns as well as tax returnsin certain other jurisdictions. The Fund records a provision for taxes in its financial statementsincluding penalties and interest, if any, for a tax position taken on a tax return (or expected tobe taken) when it fails to meet the more likely than not (a greater than 50% probability) thresh-old and based on the technical merits, the tax position may not be sustained upon examinationby the tax authorities. As of March 31, 2011, and for all open tax years, the Fund has determinedthat no provision for income tax is required in the Fund’s financial statements. Open tax yearsare those that remain subject to examination and are based on each tax jurisdiction statute oflimitation. The Fund is not aware of any tax position for which it is reasonably possible that thetotal amounts of unrecognized tax effects will significantly change in the next twelve months.

The Fund may be subject to foreign taxation related to income received, capital gains on the sale of securities and certain foreign currency transactions in the foreign jurisdictions in which it invests. Foreign taxes, if any, are recorded based on the tax regulations and rates that exist inthe foreign markets in which the Fund invests. When a capital gain tax is determined to applythe Fund records an estimated deferred tax liability for unrealized gains on these securities in anamount that would be payable if the securities were disposed of on the valuation date.

h. Security Transactions, Investment Income, Expenses and Distributions

Security transactions are accounted for on trade date. Realized gains and losses on security trans-actions are determined on a specific identification basis. Interest income and estimated expensesare accrued daily. Dividends from net investment income are normally declared daily; these divi-dends may be reinvested or paid monthly to shareholders. Distributions to shareholders aredetermined according to income tax regulations (tax basis). Distributable earnings determined ona tax basis may differ from earnings recorded in accordance with accounting principles generallyaccepted in the United States of America. These differences may be permanent or temporary.Permanent differences are reclassified among capital accounts to reflect their tax character. Thesereclassifications have no impact on net assets or the results of operations. Temporary differencesare not reclassified, as they may reverse in subsequent periods.

i. Accounting Estimates

The preparation of financial statements in accordance with accounting principles generallyaccepted in the United States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities at the date of the financial statements andthe amounts of income and expenses during the reporting period. Actual results could differ fromthose estimates.




j. Guarantees and Indemnifications

Under the Fund’s organizational documents, its officers and trustees are indemnified by the Fundagainst certain liabilities arising out of the performance of their duties to the Fund. Additionally,in the normal course of business, the Fund enters into contracts with service providers that con-tain general indemnification clauses. The Fund’s maximum exposure under these arrangementsis unknown as this would involve future claims that may be made against the Fund that have notyet occurred. Currently, the Fund expects the risk of loss to be remote.

2. SHARES OF BENEFICIAL INTEREST

At March 31, 2011, there were an unlimited number of shares authorized (without par value).Transactions in the Fund’s shares were as follows:

Six Months Ended Year EndedMarch 31, 2011 September 30, 2010

Shares Amount Shares Amount

Shares sold . . . . . . . . . . . . . . . . . . . . . . 1,264,383 $ 11,726,421 2,463,859 $ 22,012,504Shares issued in reinvestment of

distributions . . . . . . . . . . . . . . . . . . . . 197,232 1,832,810 488,765 4,361,880Shares redeemed . . . . . . . . . . . . . . . . . (1,799,350) (16,655,789) (3,542,454) (31,625,136)

Net increase (decrease) . . . . . . . . . . . . . (337,735) $ (3,096,558) (589,830) $ (5,250,752)

3. TRANSACTIONS WITH AFFILIATES

Franklin Resources, Inc. is the holding company for various subsidiaries that together arereferred to as Franklin Templeton Investments. Certain officers and trustees of the Trust are also officers and/or directors of the following subsidiaries:

Subsidiary Affiliation

Franklin Advisers, Inc. (Advisers) Investment managerFranklin Templeton Services, LLC (FT Services) Administrative managerFranklin Templeton Distributors, Inc. (Distributors) Principal underwriterFranklin Templeton Investor Services, LLC (Investor Services) Transfer agent

a. Management Fees

The Fund pays an investment management fee to Advisers based on the average daily net assetsof the Fund as follows:

Annualized Fee Rate Net Assets

0.40% First $250 million0.38% Over $250 million, up to and including $500 million0.36% In excess of $500 million



3. TRANSACTIONS WITH AFFILIATES (continued)

b. Administrative Fees

Under an agreement with Advisers, FT Services provides administrative services to the Fund.The fee is paid by Advisers based on average daily net assets, and is not an additional expense of the Fund.

c. Sales Charges/Underwriting Agreements

Distributors has advised the Fund of the following commission transactions related to the salesand redemptions of the Fund’s shares for the period:

Sales charges retained net of commissions paid to unaffiliated broker/dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,157

Contingent deferred sales charges retained . . . . . . . . . . . . . . . . . . . $ 2,152

d. Transfer Agent Fees

For the period ended March 31, 2011, the Fund paid transfer agent fees of $72,436, of which$37,023 was retained by Investor Services.

4. EXPENSE OFFSET ARRANGEMENT

The Fund has entered into an arrangement with its custodian whereby credits realized as a resultof uninvested cash balances are used to reduce a portion of the Fund’s custodian expenses. Duringthe period ended March 31, 2011, there were no credits earned.

5. INCOME TAXES

For tax purposes, capital losses may be carried over to offset future capital gains, if any. AtSeptember 30, 2010, the capital loss carryforwards were as follows:

Capital loss carryforwards expiring in:2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,223,578 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,584,050 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,817,022 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,099,588 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,076,095 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,449,042 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,929,694

$29,179,069

For tax purposes, realized capital losses occurring subsequent to October 31 may be deferredand treated as occurring on the first day of the following fiscal year. At September 30, 2010, the Fund deferred realized capital losses of $3,128,025.



5. INCOME TAXES (continued)

At March 31, 2011, the cost of investments and net unrealized appreciation (depreciation) forincome tax purposes were as follows:

Cost of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $142,660,166

Unrealized appreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,561,316Unrealized depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,436,825)

Net unrealized appreciation (depreciation) . . . . . . . . . . . . . . $ 2,124,491

Net investment income differs for financial statement and tax purposes primarily due to differingtreatments of foreign currency transactions, mortgage dollar rolls, and paydown losses.

Net realized gains (losses) differ for financial statement and tax purposes primarily due to differ-ing treatments of wash sales, foreign currency transactions, mortgage dollar rolls, financialfutures transactions, and paydown losses.

6. INVESTMENT TRANSACTIONS

Purchases and sales of investments and securities sold short (excluding short term securities) forthe period ended March 31, 2011, aggregated $274,914,403 and $270,752,170, respectively.

7. INVESTMENTS IN INSTITUTIONAL FIDUCIARY TRUST MONEY MARKET PORTFOLIO

The Fund may invest in the Institutional Fiduciary Trust Money Market Portfolio (Sweep MoneyFund), an open-end investment company managed by Advisers. Management fees paid by theFund are reduced on assets invested in the Sweep Money Fund, in an amount not to exceed themanagement and administrative fees paid by the Sweep Money Fund.

8. CONCENTRATION OF CREDIT RISK

The Fund has 15.5% of its portfolio invested in asset-backed and commercial mortgage-backedsecurities. Investments in these securities may subject the Fund to increased market volatilitywhich may cause the Fund’s net asset value per share to fluctuate. These investments may be lessliquid than other investments held by the Fund.



9. OTHER DERIVATIVE INFORMATION

At March 31, 2011, the Fund has invested in derivative contracts which are reflected on theStatement of Assets and Liabilities as follows:

Asset Derivatives Liability Derivatives

Derivative ContractsNot Accounted for as Statement of Assets and Fair Value Statement of Assets and Fair ValueHedging Instruments Liabilities Locations Amount Liabilities Location Amount

Interest rate contracts . . . Net assets consist of – Net assets consist of – net unrealized appreciation net unrealized appreciation(depreciation) $21,690a (depreciation) $ —

aIncludes cumulative appreciation (depreciation) of futures contracts as reported in the Statement of Investments. Only current day’s variation margin is reported within the Statement of Assets and Liabilities.

For the period ended March 31, 2011, the effect of derivative contracts on the Fund’s Statementof Operations was as follows:

Change in Average Unrealized Amount

Derivative Contracts Realized Appreciation Outstanding Not Accounted for as Statement of Operations Gain (Loss) (Depreciation) During Hedging Instruments Locations for the Period for the Period the Perioda

Interest rate contracts . . . Net realized gain (loss) from futurescontracts / Net change in unrealized appreciation (depreciation) on investments $(15,436) $47,675 $1,945,516

aRepresents the average notional amount for other derivative contracts outstanding during the period.

See Note 1(e) regarding derivative financial instruments.

10. CREDIT FACILITY

The Fund, together with other U.S. registered and foreign investment funds (collectively“Borrowers”), managed by Franklin Templeton Investments, are borrowers in a joint syndicatedsenior unsecured credit facility totaling $750 million (Global Credit Facility) which matures onJanuary 20, 2012. This Global Credit Facility provides a source of funds to the Borrowers fortemporary and emergency purposes, including the ability to meet future unanticipated or unusu-ally large redemption requests.

Under the terms of the Global Credit Facility, the Fund shall, in addition to interest charged onany borrowings made by the Fund and other costs incurred by the Fund, pay its share of feesand expenses incurred in connection with the implementation and maintenance of the GlobalCredit Facility, based upon its relative share of the aggregate net assets of all of the Borrowers,including an annual commitment fee of 0.08% based upon the unused portion of the GlobalCredit Facility, which is reflected in other expenses on the Statement of Operations. During theperiod ended March 31, 2011, the Fund did not use the Global Credit Facility.



11. FAIR VALUE MEASUREMENTS

The Fund follows a fair value hierarchy that distinguishes between market data obtained fromindependent sources (observable inputs) and the Fund’s own market assumptions (unobservableinputs). These inputs are used in determining the value of the Fund’s investments and are sum-marized in the following fair value hierarchy:

• Level 1 – quoted prices in active markets for identical securities

• Level 2 – other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speed, credit risk, etc.)

• Level 3 – significant unobservable inputs (including the Fund’s own assumptions in determining the fair value of investments)

The inputs or methodology used for valuing securities are not an indication of the risk associatedwith investing in those securities.

For movements between the levels within the fair value hierarchy, the Fund has adopted a policyof recognizing the transfers as of the date of the underlying event which caused the movement.

The following is a summary of the inputs used as of March 31, 2011, in valuing the Fund’sassets and liabilities carried at fair value:

Level 1 Level 2 Level 3 Total

Assets:Investments in Securities:

Mortgage-Backed Securities . . . . . . . $ — $101,838,309 $ — $101,838,309Asset-Backed Securities and

Commercial Mortgage-Backed Securities . . . . . . . . . . . . . . . . . . . — 22,496,364 — 22,496,364

Short Term Investments . . . . . . . . . . 5,094,438 15,355,546 — 20,449,984

Total Investments in Securities . . . . $5,094,438 $139,690,219 $ — $144,784,657

Financial Futures Contracts . . . . . . . . 21,690 — — 21,690

Liabilities:Securities Sold Short . . . . . . . . . . . . . — 1,987,188 — 1,987,188



12. SUBSEQUENT EVENTS

The Fund has evaluated subsequent events through the issuance of the financial statements anddetermined that no events have occurred that require disclosure.

ABBREVIATIONS

Currency Selected Portfolio

CAD - Canadian Dollar GL - Government LoanPC - Participation CertificatePL - Project LoanSF - Single Family

Franklin Strategic Mortgage PortfolioShareholder Information


Board Review of Investment Management Agreement

At a meeting held March 1, 2011, the Board of Trustees (Board), including a majority of non-interested or independent Trustees, approved renewal of the investment management agreement forthe Fund. In reaching this decision, the Board took into account information furnished throughoutthe year at regular Board meetings, as well as information prepared specifically in connection withthe annual renewal review process. Information furnished and discussed throughout the yearincluded investment performance reports and related financial information for the Fund, as well as periodic reports on expenses, shareholder services, legal, compliance, pricing, brokerage com-missions and execution and other services provided by the Investment Manager (Manager) and itsaffiliates. Information furnished specifically in connection with the renewal process included areport for the Fund prepared by Lipper, Inc. (Lipper), an independent organization, as well as addi-tional material, including a Fund profitability analysis prepared by management. The Lipper reportcompared the Fund’s investment performance and expenses with those of other mutual fundsdeemed comparable to the Fund as selected by Lipper. The Fund profitability analysis discussed the profitability to Franklin Templeton Investments from its overall U.S. fund operations, as well ason an individual fund-by-fund basis. Additional material accompanying such profitability analysisincluded information on a fund-by-fund basis listing portfolio managers and other accounts theymanage, as well as information on management fees charged by the Manager and its affiliates toU.S. mutual funds and other accounts, including management’s explanation of differences whererelevant. Such material also included a memorandum prepared by management describing projectinitiatives and capital investments relating to the services provided to the Fund by the FranklinTempleton Investments organization, as well as a memorandum relating to economies of scale anda comparative analysis concerning transfer agent fees charged the Fund.

In considering such materials, the independent Trustees received assistance and advice from and metseparately with independent counsel. In approving continuance of the investment management agree-ment for the Fund, the Board, including a majority of independent Trustees, determined that theexisting management fee structure was fair and reasonable and that continuance of the investmentmanagement agreement was in the best interests of the Fund and its shareholders. While attentionwas given to all information furnished, the following discusses some primary factors relevant to theBoard’s decision.

NATURE, EXTENT AND QUALITY OF SERVICES. The Board was satisfied with the natureand quality of the overall services provided by the Manager and its affiliates to the Fund and itsshareholders. In addition to investment performance and expenses discussed later, the Board’sopinion was based, in part, upon periodic reports furnished it showing that the investment policiesand restrictions for the Fund were consistently complied with as well as other reports periodicallyfurnished the Board covering matters such as the compliance of portfolio managers and othermanagement personnel with the code of ethics adopted throughout the Franklin Templeton fundcomplex, the adherence to fair value pricing procedures established by the Board, and the accuracy

Franklin Strategic Mortgage PortfolioShareholder Information (continued)

Board Review of Investment Management Agreement (continued)

of net asset value calculations. The Board also noted the extent of benefits provided Fund share-holders from being part of the Franklin Templeton family of funds, including the right to exchangeinvestments between the same class of funds without a sales charge, the ability to reinvest Funddividends into other funds and the right to combine holdings in other funds to obtain a reducedsales charge. Favorable consideration was given to management’s continuous efforts and expendi-tures in establishing back-up systems and recovery procedures to function in the event of a naturaldisaster, it being noted by the Board that such systems and procedures had functioned smoothlyduring the Florida hurricanes and blackouts experienced in previous years. Consideration was also given to the experience of the Fund’s portfolio management team, the number of accountsmanaged and general method of compensation. In this latter respect, the Board noted that a pri-mary factor in management’s determination of a portfolio manager’s bonus compensation was therelative investment performance of the funds he or she managed and that a portion of a portfoliomanager’s bonus was required to be invested in a predesignated list of funds within such person’sfund management area so as to be aligned with the interests of shareholders. The Board also tookinto account the quality of transfer agent and shareholder services provided Fund shareholders byan affiliate of the Manager and the continuous enhancements to the Franklin Templeton website.Particular attention was given to management’s conservative approach and diligent risk manage-ment procedures, including continuous monitoring of counterparty credit risk and attention givento derivatives and other complex instruments. The Board also took into account, among otherthings, management’s efforts in establishing a global credit facility for the benefit of the Fund andother accounts managed by Franklin Templeton Investments to provide a source of cash for tem-porary and emergency purposes or to meet unusual redemption requests as well as the strongfinancial position of the Manager’s parent company and its commitment to the mutual fund busi-ness as evidenced by its subsidization of money market funds.

INVESTMENT PERFORMANCE. The Board placed significant emphasis on the investment per-formance of the Fund in view of its importance to shareholders. While consideration was given toperformance reports and discussions with portfolio managers at Board meetings during the year,particular attention in assessing performance was given to the Lipper report furnished for theagreement renewal. The Lipper report prepared for the Fund showed its investment performanceduring 2010, as well as during the 10-year period ended December 31, 2010, in comparison to aperformance universe consisting of all retail and institutional U.S. mortgage funds as selected byLipper. The income performance for the Fund during 2010 and in each of the previous nine yearsas shown in the Lipper report was in the highest or best-performing quintile of its Lipper perform-ance universe. The Lipper report showed the Fund’s total return to also be in the highest quintile ofits performance universe in 2010, and on an annualized basis to be in the second-lowest quintile ofsuch universe for the previous three- and five-year periods, and the middle quintile of such universefor the previous 10-year period. The Board noted, in this respect, that the Lipper report showed,with the exception of 2007 and 2008, that in each year from 2001 through 2010 the Fund’s total




return was in the highest or second-highest quintile of its performance universe and that the annu-alized total return for the three- and five-year periods reflected underperformance in 2007 and 2008.The Board noted such aspect of the Fund’s comparative total returns, as well as its consistently highcomparative income return for all periods as shown in the Lipper report in finding such overallperformance as shown in the Lipper report to be satisfactory.

COMPARATIVE EXPENSES. Consideration was given to a comparison of the management feesand total expense ratio of the Fund with those of a group of funds selected by Lipper as its appro-priate Lipper expense group. Lipper expense data is based upon information taken from each fund’smost recent annual report, which reflects historical asset levels that may be quite different from thosecurrently existing, particularly in a period of market volatility. While recognizing such inherentlimitation and the fact that expense ratios generally increase as assets decline and decrease as assetsgrow, the Board believed the independent analysis conducted by Lipper to be an appropriate meas-ure of comparative expenses. In reviewing comparative costs, Lipper provides information on thecontractual investment management fee charged the Fund in comparison with the contractual invest-ment management fee that would have been charged by other funds within its Lipper expense groupassuming they were similar in size to the Fund, as well as the actual total expenses of the Fund incomparison with those of its Lipper expense group. The Lipper contractual investment managementfee analysis includes administrative charges as being part of the contractual investment managementfee, and actual total expenses, for comparative consistency are shown by Lipper for Fund Class Ashares. The Lipper expense comparisons showed that the contractual investment management feerate for the Fund was in the least expensive quintile of its Lipper expense group and its actual totalexpense rate was also in the least expensive quintile of such expense group. The Board was satisfiedwith the contractual investment management fee and total expenses of the Fund in comparison toits Lipper expense group.

MANAGEMENT PROFITABILITY. The Board also considered the level of profits realized bythe Manager and its affiliates in connection with the operation of the Fund. In this respect, theBoard reviewed the Fund profitability analysis that addresses the overall profitability of FranklinTempleton’s U.S. fund business, as well as its profits in providing management and other servicesto each of the individual funds during the 12-month period ended September 30, 2010, being themost recent fiscal year-end for Franklin Resources, Inc., the Manager’s parent. In reviewing theanalysis, attention was given to the methodology followed in allocating costs to the Fund, it beingrecognized that allocation methodologies are inherently subjective and various allocation method-ologies may each be reasonable while producing different results. In this respect, the Board notedthat while being continuously refined and reflecting changes in the Manager’s own cost accounting,the cost allocation methodology was consistent with that followed in profitability report presenta-tions for the Fund made in prior years and that the Fund’s independent registered public accountingfirm had been engaged by the Manager to review the reasonableness of the allocation methodolo-gies solely for use by the Fund’s Board in reference to the profitability analysis. In reviewing anddiscussing such analysis, management discussed with the Board its belief that costs incurred inestablishing the infrastructure necessary for the type of mutual fund operations conducted by the




Manager and its affiliates may not be fully reflected in the expenses allocated to the Fund in deter-mining its profitability, as well as the fact that the level of profits, to a certain extent, reflectedoperational cost savings and efficiencies initiated by management. The Board also took into accountmanagement’s expenditures in improving shareholder services provided the Fund, as well as theneed to meet additional regulatory and compliance requirements resulting from the Sarbanes-OxleyAct and recent SEC and other regulatory requirements. In addition, the Board considered a third-party study comparing the profitability of the Manager’s parent on an overall basis to other publiclyheld managers broken down to show profitability from management operations exclusive of distri-bution expenses, as well as profitability including distribution expenses. The Board also consideredthe extent to which the Manager and its affiliates might derive ancillary benefits from fund opera-tions, including revenues generated from transfer agent services and potential benefits resultingfrom allocation of fund brokerage and the use of commission dollars to pay for research. Basedupon its consideration of all these factors, the Board determined that the level of profits realized bythe Manager and its affiliates from providing services to the Fund was not excessive in view of thenature, quality and extent of services provided.

ECONOMIES OF SCALE. The Board also considered whether economies of scale are realized bythe Manager as the Fund grows larger and the extent to which this is reflected in the level of man-agement fees charged. While recognizing that any precise determination is inherently subjective,the Board noted that based upon the Fund profitability analysis, it appears that as some funds getlarger, at some point economies of scale do result in the Manager realizing a larger profit margin onmanagement services provided such a fund. The Board also noted that economies of scale are sharedwith a fund and its shareholders through management fee breakpoints so that as a fund grows insize, its effective management fee rate declines. The fee structure under the Fund’s investment manage-ment agreement provides an initial fee of 0.4% on the first $250 million of assets; 0.38% on the next$250 million of assets; and 0.36% on assets in excess of $500 million. The Fund had assets of approx-imately $99 million at the end of 2010, and the Board believes to the extent any economies of scalemay be realized by the Manager and its affiliates, the schedule of fees under the investment manage-ment agreement provides a sharing of benefits with the Fund and its shareholders.

Proxy Voting Policies and Procedures

The Fund’s investment manager has established Proxy Voting Policies and Procedures (Policies) thatthe Fund uses to determine how to vote proxies relating to portfolio securities. Shareholders mayview the Fund’s complete Policies online at franklintempleton.com. Alternatively, shareholders mayrequest copies of the Policies free of charge by calling the Proxy Group collect at (954) 527-7678 orby sending a written request to: Franklin Templeton Companies, LLC, 500 East Broward Boulevard,Suite 1500, Fort Lauderdale, FL 33394, Attention: Proxy Group. Copies of the Fund’s proxy votingrecords are also made available online at franklintempleton.com and posted on the U.S. Securitiesand Exchange Commission’s website at sec.gov and reflect the most recent 12-month period endedJune 30.



Quarterly Statement of Investments

The Fund files a complete statement of investments with the U.S. Securities and Exchange Commissionfor the first and third quarters for each fiscal year on Form N-Q. Shareholders may view the filedForm N-Q by visiting the Commission’s website at sec.gov. The filed form may also be viewed andcopied at the Commission’s Public Reference Room in Washington, DC. Information regarding theoperations of the Public Reference Room may be obtained by calling (800) SEC-0330.


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Franklin Templeton FundsLiterature Request. To receive a summary prospectus and/or prospectus, please call us at (800) DIAL BEN/342-5236 or

visit franklintempleton.com. Investors should carefully consider a fund’s investment goals, risks, charges and expenses

before investing. The prospectus contains this and other information. Please carefully read a prospectus before investing.

To ensure the highest quality of service, we may monitor, record and access telephone calls to or from our service

departments. These calls can be identified by the presence of a regular beeping tone.

VALUEFranklin All Cap Value FundFranklin Balance Sheet Investment FundFranklin Large Cap Value FundFranklin MicroCap Value Fund1

Franklin MidCap Value FundFranklin Small Cap Value FundMutual Beacon FundMutual Quest FundMutual Recovery Fund2

Mutual Shares Fund

BLENDFranklin Focused Core Equity FundFranklin Large Cap Equity FundFranklin Rising Dividends Fund

GROWTHFranklin DynaTech FundFranklin Flex Cap Growth FundFranklin Growth FundFranklin Growth Opportunities FundFranklin Small Cap Growth FundFranklin Small-Mid Cap Growth Fund

SECTORFranklin Biotechnology Discovery FundFranklin Global Real Estate FundFranklin Gold & Precious Metals FundFranklin Natural Resources FundFranklin Real Estate Securities FundFranklin Utilities FundMutual Financial Services Fund

GLOBALFranklin World Perspectives FundMutual Global Discovery FundTempleton Global Opportunities TrustTempleton Global Smaller Companies FundTempleton Growth FundTempleton World Fund

1. The fund is closed to new investors. Existing shareholders and select retirement plans cancontinue adding to their accounts.2. The fund is a continuously offered, closed-end fund. Shares may be purchased daily; thereis no daily redemption. However, each quarter, pending board approval, the fund will authorizethe repurchase of 5%–25% of the outstanding number of shares. Investors may tender all ora portion of their shares during the tender period.3. Effective 5/1/10, the Franklin Templeton Target Funds changed their name to the FranklinTempleton Allocation Funds. The funds’ investment goals and principal investment strategiesremained unchanged.

4. An investment in the fund is neither insured nor guaranteed by the U.S. government or byany other entity or institution.5. For investors subject to the alternative minimum tax, a small portion of fund dividends maybe taxable. Distributions of capital gains are generally taxable.6. The fund invests primarily in insured municipal securities.7. The funds of the Franklin Templeton Variable Insurance Products Trust are generally availableonly through insurance company variable contracts.

AlabamaArizonaCalifornia (4 funds)ColoradoConnecticutFloridaGeorgiaKentuckyLouisianaMarylandMassachusettsMichigan

MinnesotaMissouriNew JerseyNew York (2 funds)North CarolinaOhioOregonPennsylvaniaTennesseeVirginia

INSURANCE FUNDSFranklin Templeton Variable Insurance Products Trust7

01/11 Not part of the semiannual report

INTERNATIONALFranklin India Growth FundFranklin International Growth FundFranklin International Small Cap Growth FundMutual European FundMutual International FundTempleton Asian Growth FundTempleton BRIC FundTempleton China World FundTempleton Developing Markets TrustTempleton Emerging Markets Small Cap FundTempleton Foreign FundTempleton Foreign Smaller Companies FundTempleton Frontier Markets Fund

HYBRIDFranklin Balanced FundFranklin Convertible Securities FundFranklin Equity Income FundFranklin Income FundTempleton Income Fund

ASSET ALLOCATIONFranklin Templeton Corefolio® Allocation FundFranklin Templeton Founding Funds Allocation FundFranklin Templeton Conservative Allocation Fund3

Franklin Templeton Growth Allocation Fund3

Franklin Templeton Moderate Allocation Fund3

Franklin Templeton 2015 Retirement Target FundFranklin Templeton 2025 Retirement Target FundFranklin Templeton 2035 Retirement Target FundFranklin Templeton 2045 Retirement Target Fund

FIXED INCOMEFranklin Adjustable U.S. Government Securities Fund4

Franklin Floating Rate Daily Access FundFranklin High Income FundFranklin Limited Maturity U.S. GovernmentSecurities Fund4

Franklin Low Duration Total Return FundFranklin Real Return FundFranklin Strategic Income FundFranklin Strategic Mortgage PortfolioFranklin Templeton Hard Currency FundFranklin Total Return FundFranklin U.S. Government Securities Fund4

Templeton Global Bond FundTempleton Global Total Return FundTempleton International Bond Fund

TAX-FREE INCOME5

NationalDouble Tax-Free Income FundFederal Tax-Free Income FundHigh Yield Tax-Free Income FundInsured Tax-Free Income Fund6

Limited-/ Intermediate-TermCalifornia Intermediate-Term Tax-Free Income FundFederal Intermediate-Term Tax-Free Income FundFederal Limited-Term Tax-Free Income FundNew York Intermediate-Term Tax-Free Income Fund

State-Specific

< GAIN FROM OUR PERSPECTIVE® >

VALUE BLEND GROWTH SECTOR GLOBAL INTERNAT IONAL HYBRID ASSET ALLOCAT ION F IXED INCOME TAX-FREE INCOME

© 2011 Franklin Templeton Investments. All rights reserved. 157 S 05/11

Semiannual Report and Shareholder Letter

Franklin Strategic Mortgage Portfolio

Investment ManagerFranklin Advisers, Inc.

DistributorFranklin Templeton Distributors, Inc.(800) DIAL BEN®/342-5236franklintempleton.com

Shareholder Services(800) 632-2301

Authorized for distribution only when accompanied or preceded by a summary prospectus and/or prospectus.Investors should carefully consider a fund’s investment goals, risks, charges and expenses before investing. A prospectus contains this and other information; please read it carefully before investing.

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